Download No.356 / February 2011 The Irish Crisis Philip R. Lane

IIIS Discussion Paper
No.356 / February 2011
The Irish Crisis
Philip R. Lane
IIIS, Trinity College Dublin and CEPR
IIIS Discussion Paper No. 356
The Irish Crisis
Philip R. Lane
IIIS, Trinity College Dublin and CEPR
Disclaimer
Any opinions expressed here are those of the author(s) and not those of the IIIS.
All works posted here are owned and copyrighted by the author(s).
Papers may only be downloaded for personal use only.
The Irish Crisis* Philip R. Lane IIIS, Trinity College Dublin and CEPR Abstract This paper has three goals. First, it seeks to explain the origins of the Irish crisis.
Second, it provides an interim assessment of the Irish government’s management of
the crisis. Third, it evaluates the lessons from Ireland for the macroeconomics of
monetary unions.
* This is a revised version of a paper prepared for the conference on ‘The euro area
and the financial crisis’ (Bratislava, September 7th 2010), organised by the National
Bank of Slovakia. It is forthcoming in The Euro Area and the Financial Crisis
(edited by Miroslav Beblavy, David Cobham and Ludovit Odor), Cambridge
University Press. I thank my discussant Wendy Carlin and conference participants for
helpful feedback. I am grateful to Niamh Devitt, Peter McQuade and Donal Mullins
for helpful research assistance. This paper is part of an IRCHSS-sponsored research
project on ‘An Analysis of the Impact of European Monetary Union on Irish
Macroeconomic Policy’. Email: plane at tcd.ie.
1 1
Introduction
Ireland is in the midst of a severe crisis. While the global financial crisis has affected
all economies to varying degrees, it has been especially severe in Ireland with a
cumulative nominal GDP decline of 21 percent from Q4 2007 to Q3 2010. This ranks
Ireland among the worst-affected countries in terms of output performance during this
period (Lane and Milesi-Ferretti 2010).
Allied to this economic shock, Ireland has also experienced a severe fiscal
deterioration. After a long period of running surpluses, the fiscal balance shifted from
positive territory in 2007 to baseline deficits of 11-12 percent of GDP in 2009 and
2010. Much of this fiscal deficit is structural in nature, such that the resumption of
economic growth on its own is not sufficient to restore fiscal sustainability. In
addition, the one-off cost of recapitalising the banking system pushed the overall
general government deficit to 14.5 percent of GDP in 2009 and 32 percent of GDP in
2010, leading to rapid growth in the overall level of public debt.
The main factor behind these developments has been the devastating boom-bust cycle
in the Irish property market. Since the property boom was financed through
aggressive lending by the Irish banking system, the decline in property prices and the
collapse in construction activity has resulted in severe losses in the Irish banking
system. In turn, this has contributed to the economic crisis through a credit squeeze
2 and the fiscal crisis, both directly through the costs of recapitalising the banking
system and indirectly through the loss of asset-driven revenues.
The scale of these problems meant that the sovereign spread on Irish debt rose sharply
in 2010, with doubts concerning whether the government could achieve the triple play
of restoring economic growth, fiscal sustainability and a healthy banking system. In
the end, this resulted in a shift to official sources of funding in November 2010, with a
three-year deal agreed with the IMF and the European Union.
The primary goal of this paper is to describe what went wrong in Ireland, which is
covered in Section 2. In addition, I review the Irish government’s management of the
crisis since 2007 in Section 3. Next, I reflect on the role of Ireland’s membership of
EMU during this episode in Section 4. Section 5 concludes.
2
The boom and bust in Ireland
It is important to appreciate that there was a genuine Irish economic miracle, with
very rapid output, employment and productivity growth during the 1994-2000 period.
This period can be interpreted as an accelerated convergence phase, with Ireland
catching up with the European frontier after a long period of underperformance
(Honohan and Walsh 2002). In particular, major policy mistakes in the late 1970s had
led to an unstable macroeconomic situation that resulted in a sustained phase of
economic stagnation.
This period of stagnation came to an end with a sharp fiscal correction which was
launched in 1987 with the agreement of the main political parties and accompanied by
3 a new social partnership approach that provided a strong social consensus behind a
cooperative approach to rebuilding the economy on a pro-business platform (see also
Lane 2000). While the economy performed well in the late 1980s (supported by the
boom in major export markets such as the UK and the US), this was temporarily
halted by the 1992-1993 European recession and currency crisis. Accordingly, the
sustained period of uninterrupted economic growth really only began in 1994.
The remarkable economic performance during the 1990s was underpinned by multiple
factors. The 1987 fiscal adjustment had delivered a stable fiscal situation, while the
stagnation during the mid-1980s had eliminated the high inflation that had plagued
Ireland in the late 1970s and early 1980s. Participation rates in second-level and thirdlevel education had sharply increased throughout the 1970s and 1980s, such that new
entrants into the labour force had far higher human capital levels than those leaving
the labour force through retirement.
These positive domestic trends were accompanied by a favourable shift in the nature
of world production and world trade. In particular, the rise of the ‘weightless’
economy, in which ‘high-value, low-weight’ sectors such as computers and
pharmaceuticals were increasingly important, meant that Ireland’s peripheral
geographic status became less of a barrier to export-oriented production. The result
was a boom in inward foreign direct investment, primarily from American
multinational firms. In part, these firms selected Ireland as a platform for exporting to
the newly-unified European single market. However, a substantial proportion of the
exports were also directed towards other regions, including exports back to the US
home market.
4 With FDI providing an engine for productivity growth, domestic components of
domestic demand also picked up, such that the economic expansion was very broad in
its nature. Employment grew quickly with little pressure on wage rates, since there
was an overhang of high unemployment, a very low initial level of female
participation in the labour force and a large stock of Irish workers overseas that were
ready to return home.
While house prices began to grow strongly from around 1994, much of the initial
growth in house prices could be justified by low initial property values (in the wake of
the 1992/1993 currency crisis) and the rapid growth in income levels. Moreover,
credit expansion during the 1990s was also relatively restrained (Kelly 2010).
The rapid pace of economic growth was reinforced during 1999-2000 by the sharp
devaluation of the euro against the dollar, which boosted Irish exports. In addition,
interest rates fell in Ireland once entry into EMU was confirmed in 1997. While
Ireland undertook a revaluation in spring 1998 prior to the formation of EMU, this
was very small in scale. Moreover, Ireland had attained full employment by this stage
and strong upward pressure on wage rates became evident.
There was also substantial fiscal expansion during 2000-2001, with a rapid increase in
public spending and substantial cuts in taxation. While the ratio of public spending to
GDP declined considerably during the rapid growth of the late 1980s, the timing of
the fiscal expansion was procyclical. Accordingly, the initial years of EMU saw rapid
growth but also a big surge in inflation, with Ireland appreciating against its fellow
5 member states (Honohan and Lane 2003).
The international recession in 2001 marked a turning point for the Irish economy. The
expectation at the time was that Ireland would return to a more ‘normal’ European
growth path, since the spare capacity in the labour force had been eliminated and the
real appreciation meant that the marginal gains to foreign investors were diminishing
(at least in labour-intensive sectors such as assembly or call centres).
This projection was wrong. Rapid economic growth resumed in 2003 and was
maintained through 2007. However, the flavour of this boom was very different to the
‘Celtic Tiger’ years. In particular, it was dominated by a surge in construction
activity, with the economy driven by a boom in investment in housing and
commercial property. In turn, the positive wealth effect from rising property prices
fed into strong growth in private consumption. With tax revenues from asset-related
sources very strong, the government was also able to fund a strong pace of public
expenditure growth, while maintaining a budget surplus and enjoying a rapid decline
in the debt/GDP ratio.
The result was strong growth in employment but with little productivity growth.
While FDI still grew, it was increasingly targeted at higher-value activities that
required relatively little by way of unskilled labour, even if this sector was an
important source of demand for higher-skilled workers.
6 Figure 1. Ratio of Private Credit to GDP.
Note: Ratio of private credit by deposit money banks and other financial institutions
to GDP. Source: World Bank Financial Development Database.
The expansion in property investment was fuelled by rapid credit expansion, with the
ratio of private credit to GDP sharply increasing during 2003-2007 (see also Kelly
2010). Figure 1 shows the acceleration in credit expansion during this period.
This expansion encompassed an increase in credit provision to the household sector
but also to a small group of property developers. These property magnates acquired
large and complex portfolios that included the building of new housing estates, retail
outlets and office buildings. There was also intense competition to redevelop prime
sites in Dublin, looking to replace existing structures with higher-density complexes.
At the peak of the boom, such sites were acquired at astronomical values.
7 Figure 2. Net Foreign Liabilities of Irish Banking System
Note: Net foreign liabilities of domestic banking sector, expressed as a ratio to GDP.
Source: Author’s calculations, based on data from Central Bank of Ireland.
In addition to these domestic activities, many of these developers were also
aggressive in international acquisitions, in the London prime real estate sector, the
United States and emerging Europe. (Irish households were also highly active in
foreign property purchases, both holiday homes and buy-to-let properties.)
Much of the credit growth was provided by local banks. In turn, these banks relied
increasingly on international wholesale markets for funding, with a mix of short-term
interbank funds and international bond issues. However, there was also significant
expansion by the local affiliates of UK-headquartered funds.
The increased
competition in the market contributed to very low loan spreads and a loosening of
loan documentation standards. Figure 2 illustrates the extraordinary expansion in the
8 net foreign liabilities of the core Irish banks during this period.
Figure 3 Current Account Balance
Note: Ratio of current account to GDP. Source: Author’s calculations based on data
from Ireland’s Central Statistics Office.
Some standard feedback mechanisms amplified the boom. The collateral cycle played
an important role with rising property prices improving the net worth of domestic
investors, which in turn enabled extra leverage and a further impetus to the property
market. In related fashion, the high profitability of the domestic banking system
enabled an expansion in the balance sheets of these institutions, with a major increase
in net external liabilities. The overall current account balance shifted from near zero
in 2003 to a deficit close to 6 percent of GDP in 2007, as is shown in Figure 3.
The boost to tax revenues from asset-related sources enabled the government to add to
domestic demand, including via a heavy programme of public investment. A new
9 twist was the role played by inward migration from the new member states from 2004
onwards. Inward migration helped to limit labour cost pressures in the construction
sector, while the boost to population growth also added to investor confidence that the
underlying demand for housing would continue to grow.
Finally, the demand-led nature of the boom also contributed to a high rate of domestic
inflation. Since this meant that the short-term real interest rate was low, it boosted
borrowing and investment demand. In addition, it also boosted tax revenues due to the
non-indexation of the tax system.
There were clear signs that the property sector had passed its peak by autumn 2006.
However, the hope was that there would be a soft landing by which the decline in
property prices and construction-related activity would be gradual in nature and could
be offset by expansion in other areas. Indeed, economic activity continued to be
strong during 2007 such that the risk of a sharp crash did not seem immediate, even if
the historical cross-country evidence signalled that the likelihood of a large decline in
house prices was substantial (Kelly 2007).
As it turned out, the final trigger for the economic collapse was the shift in
international financial markets during 2007 and 2008. By early 2008, the Irish banks
found it more difficult to maintain funding in the international wholesale markets and,
at the same time, there was a more rapid pull back by domestic investors from the
property market. This period of stress culminated in a full-scale crisis in September
2008, with commercial funding for the Irish banks drying up in the wake of the
disruption of international credit markets after the collapse of Lehman Brothers. Since
10 then, Ireland has grappled with a triple crisis, with a severe decline in economic
activity, massive losses in the banking system and rapid deterioration in the fiscal
position.1 We turn to the management of the crisis in the next section.
3
Crisis management
The economic crisis
In relation to the real economy, the recession in Ireland in 2008-2009 was driven by a
dramatic decline in construction investment, with the sudden reversal in Ireland’s
fortunes also inducing a pull back in domestic consumption. In contrast to many other
advanced economies, the export sector was a stabilising factor, with the decline in
output concentrated in the domestically-oriented sectors of the economy. In a mirror
image to the boom period, negative feedback mechanisms kicked in. Banks pulled in
lending, which in turn amplified the downturn in the property sector. The increase in
bad loans further curtailed the supply of credit by Irish banks.
The decline in domestic demand also put downward pressure on the price level, with
deflation contributing to the decline in tax revenues and an increase in the real burden
of debt. Deflation was also partly driven by the sharp depreciation of sterling against
the euro, in view of the importance of imports from the UK in Irish consumption,
which constituted a terms of trade gain for Ireland. Between September 2008 and
November 2010, the cumulative decline in the CPI was 6.2 percent. Figure 4 charts
the dynamics of real GDP and nominal GDP over 1998.4 to 2010.3, expressed relative
to aggregate EMU-16 performance. The data clearly show illustrates the greater
amplitude of nominal GDP relative to real GDP, with strong relative output growth in
the first decade of EMU accompanied by above-average relative inflation and the
11 subsequent relative decline in output matched by a strong relative decline in inflation.
Figure 1. Real GDP and Nominal GDP, 1998.4 to 2010.3.
Note: Real GDP and Nominal GDP each expressed relative to aggregate EMU16
values, normalised to 100 in 1998.4. Source: Author’s calculations based on data
from Ireland’s Central Statistics Office and European Central Bank.
The recession has led to a sharp increase in unemployment, which climbed from 4.6
percent in 2007 to 13.3 percent in 2010. In addition, participation rates dropped and
net emigration resumed, so that the total fall in employment was about 12 percent.
With the decline in domestic demand, the current account has sharply improved, from
5.6 percent of GDP in 2008 to 2.4 percent of GDP in 2010.
The fiscal crisis
The downturn in domestic spending and the decline in transactions in the property
market meant that tax revenues fell very quickly, to the extent that the government
had to introduce a series of measures to obtain other sources of tax revenue and limit
public expenditure growth.
12 This included the introduction of graduated income levies, which had the effect of
sharply increasing the marginal income tax rate for middle and high earners. For
public sector workers, pay levels were de facto reduced by the introduction of a public
sector pension levy, while a recruitment freeze was also implemented.
Further
measures were taken in the 2010 budget (announced in December 2009), including
further sizeable reductions in public sector pay levels, a reduction in social benefit
levels and a contraction in spending commitments.
These measures limited the scale of the decline in the fiscal situation. Even so, the
underlying weak state of the economy and the collapse of the tax base meant that the
baseline fiscal deficits in 2009 and 2010 were still extraordinarily large at 11-12
percent of GDP, even before taking into account the one-off costs of recapitalising the
banking system.
A sizeable proportion of the deficit is structural in nature. A key problem is that
elevated revenues from asset-related sources during the boom were in part deployed
to reduce more stable types of tax revenue (see also Lane 2007). In particular, the
direct tax burden on low and middle earners was significantly reduced during this
period. In addition, the Irish tax base is quite narrow, with no significant role for
sources such as annual property taxes or local-level taxes. Accordingly, a major
challenge is to expand the tax base.
On the spending side, public pay levels and social benefit payments had been
increased quite sharply during the good years. The initial phase of fiscal adjustment
13 has already rolled back some of these gains. However, a 2010 agreement with public
sector unions means that nominal levels of public sector pay will not be further
reduced (barring exceptional circumstances), with savings to be obtained from a
combination of a recruitment freeze and productivity reforms in the delivery of public
services. A saving grace is that the decline in the construction sector means that the
cost of public investment projects has greatly declined, allowing cuts in nominal
investment spending far in excess of the decline in real spending.
The fiscal tightening measures are certainly a procyclical force that has contributed to
the scale of the recession. It would have been better to have run larger surpluses
during the good years and even accumulated a liquid rainy-day fund that might have
been deployed as a buffer against the impact of the severe negative economic shock
(Lane 1997, Lane 1998a, Lane 2010).
Taken together, the cumulative size of the discretionary fiscal tightening over 20082010 amounts to €14.6 billion, which is 9.3 percent of 2010 GDP. In November
2010, the government announced a four-year fiscal plan for 2011-2014 which would
involve a further €15 billion in discretionary fiscal tightening. In turn, this four-year
plan forms the basis for the fiscal component of the EU/IMF deal, which is further
discussed below. Under current IMF forecasts, this fiscal austerity package is
projected to stabilise the debt/GDP ratio by 2014 at 124 percent of GDP.
The banking crisis
In addition to the baseline fiscal problem, the sovereign balance sheet in Ireland has
been further strained by the government’s role in resolving the crisis in the banking
14 sector. At the end of September 2008, the most immediate concern was to stabilise
the banking system. At the time, the belief was that the main problem was the loss of
market liquidity. Accordingly, the Irish government sought to improve the funding
situation by guaranteeing the vast bulk of its liabilities for a two-year period (deposits,
senior debt and dated subordinated debt). This was followed later in 2008 by the
provision of extra capital for the banking system, as it became clear that losses on
property-related loans would be greater than previously calculated. (However, these
initial capital injections would prove small relative to subsequent estimates of the
underlying scale of potential losses.) In April 2009, the Irish government also
established the National Asset Management Agency (NAMA), with the mandate to
purchase the universe of development-related loans (above a certain value) from the
banks.
This triple-track strategy had an internal coherence, even if the execution of the
strategy turned out to be quite problematic in several respects.2 One basic problem
was that the initial guarantee of liabilities was too broad (Honohan 2010a). By
guaranteeing existing senior bonds and some types of subordinated debt, the capacity
to allocate some part of the ultimate loan losses to bondholders was compromised,
raising the taxpayer cost of resolving the banking crisis.
In relation to asset transfers, the aim was to cleanse bank balance sheets by
transferring development-related loans to NAMA, since this category was the main
source of uncertainty concerning total loan losses.
During 2009-2010, NAMA
purchased most of these loans at a steep average discount, such that the transfer also
forced the banks to crystallise the losses on these loans. Under the guidance of EU
15 rules, the discount has been applied on a loan-by-loan basis. Accordingly, there were
substantial transaction costs involved, since each individual loan had to be
individually assessed. Moreover, the cumbersome nature of this approach meant that
the transfer of loans took place slowly, which inhibited the goal of a rapid cleansing
of bank balance sheets. (Under the EU/IMF deal, the remaining transfers to NAMA
do not require loan-by-loan appraisal.)
While the asset transfer approach had the virtue of transparency, it also meant that the
banks required substantial upfront recapitalisation programmes. Only one bank (Bank
of Ireland) was able to raise significant new private capital, such that the State has
ended up with extensive control of the Irish banking system.
In turn, the high
recapitalisation costs led to a sharp increase in gross government debt and increased
the riskiness of the sovereign debt profile, in view of the ongoing uncertainties
regarding ultimate losses in the banking sector.
While all banks have suffered considerable losses, the most extreme losses (relative to
the size of loan books) were incurred by two marginal banks that have been revealed
to have had very weak corporate governance. The biggest offender has been AngloIrish Bank, which was nationalised in early 2009. While it had little presence in the
retail deposit market, this bank had grown very rapidly through aggressive propertyrelated lending which was largely funded on wholesale markets. The losses at this
bank have been by far the largest contributor to the overall losses in the Irish banking
system. In addition, a smaller mutual bank (Irish Nationwide Building Society or
INBS) has also incurred catastrophic property-related losses. However, the losses at
the two main commercial banks (Bank of Ireland and AIB) and the tail-risk exposures
16 of these banks to further deterioration in the economy has meant that the entire
banking system has been compromised.
While the public capital injections into Bank of Ireland and AIB may be viewed as
financial investments that may ultimately yield a return, the capital poured into
Anglo-Irish Bank and INBS is effectively a write-off. The capital transfers to AngloIrish Bank and INBS pushed the overall 2009 general government balance to 14.5
percent of GDP and the 2010 balance to 32 percent of GDP.
The EU/IMF deal
The Irish government ultimately requested assistance from the EU and IMF in
November 2010. There were several triggers for this decision. In relation to the
banking system, the expiry of the State guarantee in September 2010 led to an exit of
private-sector funders that had committed funding under the guarantee. In turn, this
resulted in a marked increase in the reliance of the Irish banks on liquidity support
from the ECB and the extraordinary liquidity assistance facility of the Irish central
bank. Apparently, the view from the ECB was that this liquidity support could only
be maintained if the process of downsizing the Irish banking system were accelerated
and the capital ratios of the Irish banks further improved as a buffer against tail-risk
losses.
In addition, the projected level of property-related losses had increased over summer
2010, with the discounts on the second tranche of loan transfers to NAMA greater
than expected. In addition, the new management team at Anglo-Irish Bank decided to
make extra provisions on non-NAMA loans, requiring further capital injections into
17 Anglo-Irish Bank.
Figure 5 Spread between Ten-Year Bonds: Ireland over Germany. Note: Yield spread on ten-year government bonds. Source: Author’s calculations
based on data from Global Financial Data.
These extra capital requirements contributed to increased market concerns about the
sustainability of the fiscal position. More generally, the surprise nature of the extra
provisions underlined the extent of the uncertainty surrounding estimates of total loan
losses in the Irish banking system and this tail risk pushed up the spread on Irish
sovereign debt (Figure 5).
Furthermore, a downward revision to the 2009 GDP data was announced in June 2010
and the publication of lower growth forecasts in the IMF Article IV report in July
2010 led to a re-assessment of the scale of the adjustment that would be needed to
achieve a sustainable fiscal position. In part, these lower GDP forecasts related to a
more pessimistic view of the impact of the financial crisis on the medium-term trend
18 growth rate for the economy. However, an additional factor was a greater recognition
that the adjustment process would involve a sustained real depreciation, in which the
growth in the GDP deflator would be negative in the short-term and only increase
slowly over the medium term, such that the five-year projection for nominal GDP was
much lower than previously estimated.
The total financial package under the EU-IMF deal is valued at €85 billion, which is
about 54 percent of 2010 GDP for Ireland. However, €17.5 billion of the total is
domestically sourced, from the assets held by Ireland’s sovereign wealth fund (the
National Pension Reserve Fund) and the cash balances held by the agency responsible
for managing the national debt (the National Treasury Management Agency). The
external component of €67.5 billion is evenly split with €22.5 billion from the
European Commission’s European Financial Stability Mechanism (EFSM); €22.5
billion from the International Monetary Fund (IMF); and €22.5 billion from the
European Financial Stability Fund (EFSF) and bilateral loans (from the UK, Sweden
and Denmark).
In terms of composition, the intention is that €50 billion can provide funding to the
Irish State, such that Ireland need not primarily rely on the bond markets to fund its
fiscal deficit or roll over existing debt over the next three years. (Although the
programme does require Ireland to have partial access to market funding from 2012
onwards.) In relation to the banking system, €10 billion is to be drawn down to
provide extra capital to the Irish banking system (€8 billion) and fund credit
enhancements that are intended to allow the Irish banks to sell packages of risky loans
to private investors (€2 billion). The final €25 billion is contingent funding that can be
19 drawn down if its turns out that the Irish banking system requires yet further capital in
the coming years.
The agreed programme involves discretionary fiscal tightening of €15 billion over
2011-2014, with €6 billion of this total to take place in 2011. Under an optimistic
growth scenario, this might deliver a budget deficit to GDP ratio in 2014 that is just
under the 3 percent limit. However, the programme recognises that a lower growth
path would not see the 3 percent target achieved by 2014. Under that scenario, the
programme envisages that further tightening will be required in 2015, in order to
achieve the 3 percent target.
The combined interest rate across the different funding lines is of the order of 5.8
percent per annum for a 7.5 year loan. While this is in line with standard IMF funding
conditions, it is arguable that the European component of the funds could have been
priced at a lower rate. While it is certainly important that such official funding
contains a premium to discourage moral hazard, the 300 basis point premium built
into this funding rate makes it more difficult to achieve fiscal sustainability. This
limits the degree of solidarity across EU partners, while also increasing the risk facing
other European governments in view of the potential contagion from doubts about the
sustainability of the Irish sovereign position.
Although the context is quite different, it is striking that the December 2010
agreement between Iceland and the UK and Dutch governments on the Icesave debt
specifies an interest rate of 3.2 percent over a long repayment period, with the interest
rate calculated to approximate the cost of funds for the creditor governments.
20 Similarly, the balance of payments support provided by the European Commission to
EU member countries outside the euro area (Hungary, Latvia) does not carry a similar
penalty premium.
In terms of structural reforms, the main objective under the deal is to de-risk the
banking system (see also Honohan 2010c, Honohan 2011). This involves several
elements. First, the extra capital injections are intended to increase in core Tier 1
capital ratios to 12 percent. Second, the level of risky loans held by the banks are to
be reduced through the transfer of extra property loan tranches to NAMA and the sale
of loan packages to private investors. (As indicated above, the sale of loan packages
to private investors will be supported by €2 billion in credit enhancements to limit the
risk exposure that would otherwise deter private investors.) Third, the banks will be
further downsized through the disposal of affiliates and other non-core assets. Fourth,
the winding down of the main disaster banks (Anglo-Irish Bank and Irish Nationwide
Building Society) will be accelerated. Fifth, the €25 billion in contingent funding
provides an additional buffer in the event of extra loan losses.
Finally, these financial measures will be accompanied by a more extensive third-party
assessment of the quality of the loan books. While the Irish central bank published a
prudential capital assessment review (PCAR) in March 2010 that set out conservative
provisions for loan losses (this was updated in September 2010), the level of
uncertainty about loan quality means that further information disclosure is necessary
in order to improve market understanding of the likely distribution of loan losses.
Furthermore, the role of third-party assessors in examination of the loan books is seen
as important in guaranteeing the rigour of the 2011 PCAR exercise. If it turns out that
21 the review signals that extra bank capital is advisable, this is allowed for under the
terms of the EU/IMF funding.
Taken together, the goal is that these banking sector reforms will result in a smaller,
less-risky and better-capitalised banking system. In turn, these changes improve the
sustainability of the ECB liquidity provisions and also increase the likelihood that the
Irish banks can return to the private wholesale funding markets.
An important issue in the negotiation of the deal was the appropriate scale of burden
sharing by bank bondholders in the recapitalisation of the Irish banking system. If the
holders of bonds issued by the Irish banks absorbed some of the losses, the fiscal
burden would be lightened. It seems that there were about €32 billion of nonguaranteed bank bonds outstanding at the time of the EU-IMF deal, consisting of €12
billion of subordinated debt and €20 billion of senior debt. These are bonds that were
issued before the introduction of the September 2008 guarantee (which has now
expired) but have not yet reached their maturity dates. In addition, about €25 billion
of guaranteed senior bonds have been issued under the 2009 Eligible Liabilities
Guarantee scheme for new debt issuance.3 (A small amount of new non-guaranteed
bonds has also been issued.)
The EU-IMF deal envisages that holders of subordinated debt will not be repaid in
full. There is currently a bond exchange programme for the Anglo-Irish subordinated
debt which offers the bond holders 20 cents on the euro. Over the last two years, there
have been other voluntary exchange programmes for subordinated debt holders in
several banks, with an estimated €7 billion obtained in discounts. (It is arguable that
22 these earlier exchange programmes were premature in that the appropriate level of
discount could not be properly determined before the full systemic evaluation of
prospective loan losses had taken place.)
However, it also seems that there was serious discussion of writing down the value of
some non-guaranteed senior bonds as part of the IMF/EU negotiations. While the
legal tradition in Ireland has been to view senior bonds as pari passu with depositors,
it seems that there may be legal options to break that link. For instance, in situations
in which the scale of State capital injections exceeds the pre-crisis level of capital, it
may be possible to argue that senior bondholders should have no legitimate
expectation of full repayment.
However, no agreement was reached for restructuring the non-guaranteed senior
bonds. Media reports indicate that European policymakers took the view that the
restructuring of senior debt would create a new precedent in European banking that
could severely disrupt bank funding markets. However, the counter-argument is that a
set of objective criteria could be developed that would clearly delimit the scenarios
under which some types of senior debt should be written down, thereby limiting the
scope for contagion.
Indeed, the working document of European Commission (2011) identifies a range of
possible criteria, even if the scope of the European Commission report is restricted to
the design of future bank bond contracts, rather than to altering the payoffs on
existing bank debt. Moreover, to the extent that the restructuring of senior bank
bonds improves the sovereign fiscal position, it might even be a calming influence on
23 sovereign debt markets. The ultimate treatment of the non-guaranteed senior bank
bonds remains an unresolved issue and is set to feature in the political debate
surrounding the upcoming general election in Ireland.
In terms of other structural reforms, the main priority is to improve the operation of
the labour market in order to facilitate a reversal in the sharp increase in
unemployment (much of it now long-term) since the onset of the crisis. The minimum
wage (set at the peak of the boom) has been reduced by 12 percent, while there has
been a further 4 percent decline in unemployment benefits. In addition, more vigorous
labour market activation policies are envisaged under the plan and other types of
rigidities in the wage setting system will be targeted. In relation to product markets,
there are aspirations to reduce monopoly rents in sheltered sectors (such as the legal
and medical professions) and boost productivity in the public sector.
However, the growth payoff from such reforms may occur with a long lag and cannot
be relied on to improve growth substantially within the period of the deal. Similarly,
public sector reform has the potential to boost efficiency considerably, but the overall
growth payoff will only occur over a long period. Accordingly, it is not realistic to
expect a sizeable direct short-term growth payoff.
Overall, the EU/IMF deal provides an environment in which Ireland can make
progress in resolving its crisis. However, there are considerable implementation
challenges in delivering the planned fiscal adjustment (see also Beetsma et al 2009).
In addition, the cost of restructuring the banking system remains uncertain and
depends on the ability to sell bank assets at prices above fire sale values.
24 Both the debt dynamics and the health of the banking sector are dependent on the rate
of nominal GDP growth in the coming years. In this regard, there is considerable
uncertainty about the path for GDP. The Irish finance ministry and the main local
economic forecaster (the ESRI) are relatively optimistic about the speed of output
growth, pointing to the capacity for a small open economy to rely on export-driven
growth and the high current levels of precautionary savings that should decline once
uncertainty declines and consumer confidence recovers. Against that view, the crosscountry historical evidence is that output growth is typically very slow after major
banking crises, even if these historical examples do not precisely match the current
Irish conditions (Reinhart and Reinhart 2010).
Having reviewed the course of events in Ireland, we now turn to asking some general
questions about the lessons to be drawn from the Irish experience in relation to the
impact of EMU on member countries.
4
Ireland and EMU
At a surface level, it is possible to argue that membership of EMU has directly
contributed to the boom-bust cycle in Ireland.4 First, Ireland entered EMU at the peak
of the Celtic Tiger output boom, with full employment only recently achieved and the
emergence of shortages in the labour market. Accordingly, the initial conditions for
Ireland were quite different than for the aggregate euro area economy.
A standard prescription in this case is to revalue the exchange rate prior to entering
the monetary union, such that price level pressures in the economy are diverted into
25 nominal exchange rate appreciation rather than a differential post-entry inflation rate.
While Ireland undertook a small revaluation in spring 1998, this was inadequate given
the scale of the boom.5 Accordingly, the undervalued conversion rate between the
Irish pound and the euro contributed to the inflationary pressures in Ireland in the
early years of EMU.
Second, the creation of EMU itself represented an asymmetric shock. In particular,
while the core member countries had experienced a convergence in interest rates long
before the formation of EMU, there was a substantial decline in interest rates for
peripheral member countries such as Ireland, Portugal, Spain and Greece in the late
1990s. For these countries, a history of devaluations meant that there was a substantial
country risk premium in interest rates. Moreover, the smaller countries suffered from
a low level of liquidity in their money and currency markets, such that a liquidity
premium was also incorporated into the level of interest rates in these countries.
Accordingly, EMU represented a major economic shock for them, since devaluation
risk and currency liquidity risk were eliminated. As such, holding fixed other factors,
households, firms and governments in these countries now faced a permanent
reduction in the cost of capital. In turn, this triggered an expenditure boom in these
countries (see also Fagan and Gaspar 2007).
Third, by virtue of its greater involvement in extra-EMU trade, Ireland was more
affected by shifts in the external value of the euro than was the case for other member
countries. In particular, the sharp depreciation of the euro against the dollar during
1999-2002 represented a positive differential shock for Ireland vis-à-vis the rest of the
euro area, since the strong economic linkages between Ireland and the United States
26 meant that Irish competitiveness was boosted by more than in other countries. This
contributed to the already-strong aggregate demand conditions in Ireland during that
period and the positive inflation differential between Ireland and the rest of the euro
area (Honohan and Lane 2003). More recently, the rapid depreciation of sterling
against the euro during autumn 2008 has affected the Irish economy more than other
regions in the euro area.
Fourth, the effective segmentation of national banking systems that remained even
after the formation of EMU meant that shifts in market structure in the Irish banking
system posed a challenge for the domestic financial regulator. In particular, aggregate
credit growth in Ireland was boosted by the rise of Anglo-Irish Bank as an aggressive
lender to property developers, which in turn induced a relaxation of lending standards
by other participants in the Irish loans market (Honohan 2009, 2010a, 2010b). In
similar fashion, greater competition from the affiliates of UK banks further
contributed to rapid domestic credit growth. In turn, this domestic credit boom
contributed to faster expansion in Irish aggregate demand relative to other members of
the euro area and increased country-specific risks in the banking system.
Fifth, there have been major shifts in government spending and taxation in Ireland
relative to other members of the euro area since 1999. Membership of a monetary
union is perfectly consistent with a wide range of variation in terms of the ratios of
government spending and tax revenues to GDP. However, the timing of the fiscal
expansion was procyclical in nature, such that fiscal policy tended to amplify cyclical
divergences between Ireland and the rest of the euro area economy.6
27 Sixth, the asymmetric liberalisation of EU labour markets to migrants from the new
member states in 2004 represents a further idiosyncratic shock. In particular, Ireland
was the only member of the euro area to open its labour market to workers from
Central and Eastern Europe and only the United Kingdom and Sweden adopted a
similar approach among the existing members of the EU. The scale of postliberalisation migration far exceeded ex-ante expectations, acting as another structural
shock for the Irish economy that was not shared by its fellow members of the euro
area.
Taken together, these country-specific factors meant that macroeconomic stability in
Ireland required effective national stabilisation policies. However, there was a failure
to regulate the banking sector to guard against systemic risk factors. This was
especially problematic under EMU, since access to the area-wide financial markets
meant that the scope for Irish banks to take on too much risk was amplified.
Moreover, the operation of fiscal policy was insufficiently counter-cyclical. These
twin policy weaknesses both failed to curb the boom and exacerbated the scale of the
crisis.
The weaknesses in banking regulation have been extensively analysed in two major
reports that were commissioned by the Irish government (Honohan 2010a, Regling
and Watson 2010). As a follow on to these reports, a banking inquiry has been
established to further probe into these regulatory failures. This should prove helpful
in establishing in more detail the factors that contributed to the banking crisis.
However, major required reforms have already been implemented, with new senior
appointments at the Central Bank and a reorganisation of the system of financial
28 regulation.
In relation to fiscal policy, there were both macroeconomic and microeconomic
weaknesses (see also Lane 2010). While budget surpluses were run during the boom
period, these were relatively small and the scale of the structural deficit was
systematically underestimated (by both domestic and international agencies). On net,
the fiscal position was fundamentally fragile, despite appealing headline numbers. In
relation to microeconomics, the tax system during the boom period provided
excessive incentives to invest in property - and these distortions amplified the cycle.
Accordingly, the lesson is that the fiscal system needs to be redesigned in order to be
more robust in the event of future shocks. A broader tax base should help to provide a
more stable platform for tax revenues, while the setting of tax rates should be countercyclical or at least acyclical. In relation to the fiscal balance, the crisis has illustrated
that a small open economy such as Ireland should run much bigger surpluses during
boom periods in order to provide fiscal space during downturns. An important current
debate is whether formal fiscal rules and a role for an independent fiscal council can
facilitate a more countercyclical pattern for fiscal policy (Lane 2010). Indeed, the
EU/IMF deal includes a commitment to introduce a Fiscal Responsibility Law and a
Budgetary Advisory Council in the first half of 2011.
The failure to implement appropriate national stabilisation problems meant that
Ireland took excessive macroeconomic risks during the early years of EMU. In turn,
membership of a currency union limits the range of options that can be pursued in
emerging from the current crisis. However, along some dimensions, membership of
29 the euro area has also provided considerable stability during this crisis period. Most
directly, the Irish banks have heavily relied on the liquidity provided by the European
Central Bank as a substitute for the loss of access to private wholesale funders. In
addition, highly-indebted Irish households have benefited from low ECB interest rates
during the crisis.
Had Ireland not joined the euro, the foreign liabilities of the banking system would
most likely have been in foreign currency and the banking crisis would have been
amplified by a parallel currency crisis. Moreover, an independent currency would not
have offered a guarantee against the onset of the mid-2000s credit boom. This credit
boom affected many non-EMU economies in Europe (Iceland, Central and Eastern
Europe) and many countries have experienced the problems associated with currency
overshooting that can act to amplify the impact of credit booms, only to be followed
by a deeper crash with currency depreciation exacerbating balance sheet problems.
Moreover, even under an independent monetary policy, it is not clear that the central
bank would have been able to neuter the housing boom solely through its interest rate
policy, in view of the weak relation beween interest rates and housing prices and the
potential output costs of targeting asset prices ahead of real indicators (Dokko et al
2011).
Of course, there are some attractions to an ‘immaculate’ devaluation by which a oneoff realignment of the Irish real exchange rate could provide a boost to exports.
However, as is exhaustively documented by Eichengreen (2010), there are
considerable financial and logistical disruptions associated with seeking to exit the
euro. In view of Ireland’s very deep level of international financial and economic
30 integration, these transition costs might be especially high.
Moreover, the longer-term attractions of an independent currency remain open to
question for the reasons given above. Such problems would be especially severe for a
new currency created in the wake of exiting EMU, since the credibility of the new
monetary regime and its anti-inflation commitment would be queried by the markets.
Accordingly, the monetary regime for a new Irish currency would likely require an
initial phase of relatively high interest rates.
In terms of the broader reform of the institutional framework for the euro area, the
failures in domestic macroeconomic policy and financial regulation during the precrisis period mean that the proposals by the European Commission for tighter
surveillance are welcome in terms of reducing the risk of future crisis episodes.
However, the absence of an EU-wide special resolution regime for failing banks has
made it more difficult and more costly to resolve the Irish banking crisis. In relation to
future crises, the types of proposals currently being developed by the European
Commission should help (for instance, in allowing for the bailing in of senior
unsecured bond holders in the event of severe bank losses) but these are too late to be
helpful in resolving the current crisis. More broadly, the creation of the European
Systemic Risk Board and the associated European Supervisory Authorities should
help in monitoring European-wide risks in the financial system.
While the creation of the European Financial Stability Facility (EFSF) has facilitated
the funding of the IMF/EU programme for Ireland, the size of the penalty premium
31 built into the interest cost is arguably too stiff for a fund that is built on the principles
of solidarity and common financial interests among members of the euro area, since it
is sufficiently high to non-trivially increase the risk that the sovereign will ultimately
run into repayment difficulties.
Furthermore, the EFSF can only provide loans to member governments. In terms of
promoting financial stability, a more flexible mechanism that could also offer tail-risk
insurance might have been better suited to tackling the underlying fiscal exposure of
the Irish government in relation to resolving the Irish banking crisis (see also
Honohan 2011).
The current proposals for the permanent European Stabilisation Mechanism (ESM)
that will replace the EFSF in 2013 do not extend the remit of the ESM to include this
type of risk sharing mechanism. However, the greater clarity about the potential for
burden sharing by bondholders under the ESM should prove helpful in providing
greater market discipline in relation to future fiscal management. However, the
uncertainty about the transition towards the ESM arrangements is a source of
instability in dealing with the current sovereign debt crisis.
5
Conclusions
The 2003-2007 property-driven boom has proven to be very costly for Ireland,
resulting in a deep recession, a severe fiscal crisis and the near-collapse of the
banking system. While the frothy state of international financial markets and the
under-pricing of risk certainly played a role in fuelling the boom, the primary
responsibility for curbing excesses lay with domestic policymakers. In this regard,
32 there was a twin failure with the financial regulator losing control of systemic
financial risk, while fiscal policy was insufficiently counter-cyclical.
By the same token, although the 2007-2008 international financial crisis was the
proximate trigger for the hard landing in the domestic property market, the unwinding
of the boom was bound to happen at some point, even if the nature of the inevitable
adjustment might have been different under alternative realisations.
At a domestic level, a primary lesson from the Irish crisis is that it reaffirms the
principle that rigorous discipline in fiscal policy and financial regulation is essential if
membership of a currency union is to be compatible with macroeconomic and
banking stability. At an EU level, the Irish crisis has highlighted the costs of the
incomplete institutional design of the monetary union and the importance of deeplevel reforms both to reduce the probability of future crises and to increase the
resilience of the European banking system in the event of a crisis.
33 Notes
1
The crisis in Ireland has other dimensions, including the damage to Ireland’s
international reputation and a loss of confidence among the domestic population in the
2
Other approaches to resolving the banking crisis were also debated. For instance, the
pre-emptive nationalisation of the banking system was advocated by many domestic
economists and also raised by the 2009 IMF Article IV mission.
3
The main focus of the debate is on the non-guaranteed bonds, since a restructuring of
guaranteed bonds would have broader implications for sovereign debt.
4
This section draws on Lane (2009).
5
Lane (1998a) recommended that Ireland undertake a much larger revaluation.
Slovakia revalued by 15 percent in 2008 before it joined EMU at the beginning of
2009.
6
Lane (1998c) and Hunt (2005) analyse the long-standing procyclical pattern in Irish
fiscal policy.
34 References
Beck, T., A. Demirgüç-Kunt and R. Levine, (2000), "A New Database on Financial
Development and Structure," World Bank Economic Review 14, 597-605.
Beetsma, R., M. Giuliodori and P.R. Wierts (2009), ‘Budgeting versus Implementing
Fiscal Policy in the EU’, Economic Policy 24: 753-804.
Dokko, J., B. Doyle, M.T. Kiley, J. Kim, S. Sherlund, J. Sim, and S. Van Den Heuvel
(2011), ‘Monetary Policy and the Global Housing Bubble’, Economic Policy,
forthcoming.
Eichengreen, B. (2010), ‘The Breakup of the Euro Area’, in A. Alesina and F.
Giavazzi (eds) Europe and the Euro, University of Chicago Press.
European Commission (2011), ‘Technical Details of a Possible EU Framework for
Bank Recovery and Resolution’, DG Internal Market and Services Working
Document.
Fagan, G., and V. Gaspar (2007), Adjusting to the Euro, ECB Working Paper No.
716.
Honohan, P. (2009), ‘Resolving Ireland’s Banking Crisis’, Economic and Social
Review 40(2): 207-232
Honohan, P. (2010a), The Irish Banking Crisis – Regulatory and Financial Stability
Policy 2003-2008.
Honohan, P. (2010b), ‘Euro Membership and Bank Stability: Friends or Foes?’,
Comparative Economic Studies 52, 133-157.
Honohan, P. (2010c), ‘Financial Regulation: Risk and Reward,’ Speech to
International Financial Services Summit, November 10.
Honohan, P. (2011), ‘Restoring Ireland’s Credit By Reducing Uncertainty’, IIEA
Speech, January 7.
35 Honohan, P. and P.R. Lane (2003), ‘Divergent Inflation Rates under EMU’,
Economic Policy 37: 358-394.
Honohan, P. and B. Walsh (2002), ‘/Catching Up with the Leaders: The Irish Hare’,
Brookings Papers on Economic Activity 2002: 1-79.
Hunt, C. (2005), ‘Discretion and Cyclicality in Irish Budgetary Management 19692003’, Economic and Social Review 36: 295-321.
Kelly, M. (2007), ‘On the Likely Extent of Falls in Irish House Prices,’ Quarterly
Economic Commentary, Summer 2007, 42-54.
Kelly, M. (2010), ‘Whatever Happened to Ireland?,’ CEPR Discussion Paper No.
7811.
Regling, K. and M. Watson (2010), A Preliminary Report on the Sources of Ireland’s
Banking Crisis.
Lane, P.R. (1997), ‘EMU: Macroeconomic Risks’, Irish Banking Review [Spring], 2434.
Lane, P.R. (1998a), ‘EMU Demands Awareness of the Big Picture’, Irish Times
[February 02 1998].
Lane, P.R. (1998b), ‘Irish Fiscal Policy under EMU’, Irish Banking Review [Winter],
2-10.
Lane, P.R. (1998c), ‘On the Cyclicality of Irish Fiscal Policy’, Economic and Social
Review 29: 1-16.
Lane, P.R. (2000), ‘Disinflation, Switching Nominal Anchors and Twin Crises: The
Irish Experience’, Journal of Policy Reform 3: 301-326.
Lane, P.R. (2007), ‘Fiscal Policy for a Slowing Economy’, in Budget Perspectives
2008, Economic and Social Research Institute.
Lane, P.R. (2009), ‘European Monetary Union and Macroeconomic Stabilisation
36 Policies in Ireland’, Report Prepared for National Economic and Social Council.
Lane, P.R. (2010), ‘A New Fiscal Framework for Ireland’, Journal of the Statistical
and Social Inquiry Society of Ireland XXXIX: 144-165.
Lane, P.R. and G.M. Milesi-Ferretti (2010), ‘The Cross-Country Incidence of the
Global Crisis’, IMF Economic Review, forthcoming.
Reinhart, C., and V.R. Reinhart (2010), ‘After the Fall,’ in Macroeconomic
Challenges: The Decade Ahead,
Federal Reserve Bank of Kansas City
Economic Policy Symposium, forthcoming.
37 Institute for International Integration Studies
The Sutherland Centre, Trinity College Dublin, Dublin 2, Ireland